458 CHAPTER 12 Corporate Valuation, Value-Based Management, and Corporate Governance
hurts shareholders in two ways. First, they are left with $20 stock when they could
have received $30 per share. Second, the company purchased stock from the bidder
at $35 per share, which represents a direct loss by the remaining shareholders of $15
for each repurchased share.
Managers who buy back stock in targeted repurchases typically argue that their
firms are worth more than the raiders offered, and that in time the “true value” will
be revealed in the form of a much higher stock price. This situation might be true if
a company were in the process of restructuring itself, or if new products with high
potential were in the pipeline. But if the old management had been in power for a
long time, and if it had a history of making empty promises, then one should ques-
tion whether the true purpose of the buyback was to protect stockholders or man-
agement.
Another aspect of a stockholder-friendly charter is that it does not contain a
shareholder rights provision,better described as apoison pill.These provisions
give the shareholders of target firms the right to buy a specified number of shares in
the company at a very low price if an outside group or firm acquires a specified per-
centage of the firm’s stock. Therefore, if a potential acquirer tries to take over a
company, its other shareholders will be entitled to purchase additional shares of
stock at a bargain price, thus seriously diluting the holdings of the raider. For this
reason, these clauses are called poison pills, because if they are in the charter, the ac-
quirer will end up swallowing a poison pill if the acquisition is successful. Obviously,
the existence of a poison pill makes a takeover more difficult, and this helps to en-
trench management.
A third management entrenchment tool is arestricted voting rights provi-
sion, which automatically deprives a shareholder of voting rights if the share-
holder owns more than a specified amount of stock. The board can grant voting
rights to such a shareholder, but this is unlikely if the shareholder plans to take
over the company.Effective Monitoring by a Strong Boar dof Directors High compensation
and prestige go with a position on the board of a major company, so board seats
are prized possessions. Board members typically want to retain their positions, and
they are grateful to whoever helped get them on the board. This situation has im-
portant implications for corporate governance as it affects stockholders. First, note
that 30 years ago a firm’s CEO was in all likelihood also the chairman of its
board. Moreover, many of the other board members were “insiders,” that is, peo-
ple who held managerial positions within the company, such as the CFO. The
CEO, who could remove them from their inside position if they raised objections
to his policies, generally nominated them to the board. Even outside board mem-
bers usually had strong connections with the CEO through personal friendships,
consulting or other fee-generating activities, orinterlocking boards of directors,
where Company A’s CEO sits on Company B’s board and B’s CEO sits on A’s
board. In these situations, even the outside directors are not truly independent and
impartial.
Under an “old boy network” board as described above, the CEO had a much
more protected position than is typical today. Now most boards are comprised pri-
marily of outsiders who are not beholden to the CEO, which makes it much more
likely that an ineffective CEO will be removed. Also, in the earlier period board
members were compensated in the form of salary, whereas today directors are gener-
ally given stock or options, so an ineffective management team costs the directors
money. The changes in director compensation, together with directors’ greater